Full opinion text
MEMORANDUM OPINION AND ORDER GRAHAM, District Judge. Introduction This is a tax refund suit initiated by American Electric Power Company, Inc. (“AEP”) to recover an alleged overpayment of federal income tax with respect to its 1996 tax year. AEP is a public utility holding company organized under the laws of the State of New York. Its principal office is in Columbus, Ohio. AEP is one of the largest shareholder-owned electric utility companies in the United States, operating in Ohio, Indiana, Kentucky, Michigan,' Tennessee, Virginia, and West Virginia. AEP owns various operating, service, and coal-producing subsidiary corporations. The amount of tax in dispute with respect to the 1996 tax year for all the AEP companies is $25,478,773. The resolution of the tax controversy in this case will affect other AEP tax years, including 1991 to 1995,1997 and 1998. This case arises out of AEP’s participation in a highly leveraged broad-based program of corporate-owned life insurance (“COLI”), wherein AEP purchased life insurance policies on the lives of over 20,000 employees constituting most of its work force. AEP was the beneficiary of these life insurance policies. A substantial amount of the premium cost for the COLI policies was financed by loans secured by the cash value of the policies. The COLI program was designed to maximize the tax benefits of the deductibility of interest on the policy loans, the deferral of taxation on the increase in cash value, and the ultimate non-taxability of the death benefits. The Internal Revenue Service (“IRS” or “government”) has disallowed AEP’s deductions for interest paid on the COLI policy loans for 1996. The government claims that the policy loans, dividends, and partial withdrawals of policy value, which were used to pay premiums, lacked factual or economic substance and were sham transactions, i.e., that they were shams in fact. Alternatively, the government maintains that the AEP COLI plan, taken as a whole, had no practical economic consequences, other than the creation of income tax benefits, and therefore, was a sham in substance. The government also contends that when these transactions are viewed in their proper ■ light, the relationship of AEP’s borrowing to its net premiums, i.e. gross premiums minus dividends and partial withdrawals, the plan fails the “four of seven” test set forth in I.R.C. § 264(c)(1). The Internal Revenue Code generally disallows deductions on amounts borrowed on an insurance policy to pay premiums. See I.R.C. § 264(a)(3). However, this exclusion does not apply if “no part of 4 of the annual premiums due during the 7-year period (beginning with the date the first premium on the contract to which such plan relates was paid) is paid under such plan by means of indebtedness!.]” § 264(d)(1) (known as the “four out of seven safe harbor”). AEP contends that its COLI plan and its use of policy loans, policyholder dividends, and withdrawals to pay premiums and accrued policy loan interest were all within the intendment of the provisions of the Internal Revenue Code that governed the federal income tax treatment of life insurance and the deductibility of interest on policy loans during the years in question. AEP asserts that the policy loans, dividends and policy withdrawals were real transactions. AEP also claims that its COLI plan had objective economic substance and was undertaken for a valid business purpose, and that the interest on the policy loans was properly deductible under I.R.C. § 163(a). General principles of life insurance This case involves many of the unique attributes of life insurance. There are two basic kinds of life insurance: term insurance, which, as its name implies, provides a death benefit for a specified term of years; and whole life insurance, which provides a death benefit throughout the lifetime of the insured. Term insurance policies are priced on the basis of the actu-arially-determined cost of providing the stipulated death benefit during the term of the policy. This is referred to in the insurance industry as the cost of insurance (“COI”). The premium for a term insurance policy includes a profit for the insurance company, but the contract provides no benefits to the insured other than the death benefit. Whole life policies, on the other hand, are customarily priced to permit the accumulation of value in addition to the cost of providing the death benefit. These policies provide a benefit known as cash value, which may be accessed by the policyholder during the insured’s lifetime through policy loans or withdrawals of policy value. The accumulation of cash value within the policy may be likened to a savings account. The cash value of the policy represents not only the excess of premi-urns over COI charges, but also additional credits added by the insurance company in the nature of interest. The source of these additional credits is the income generated by the insurance company’s investments. This additional contribution to cash value is referred to as “inside buildup.” The owner of a whole life insurance policy which has accumulated cash value has a contractual right to obtain a loan from the insurance company, referred to as a policy loan, whereby the policyholder pledges the cash value of the insurance policy as collateral for the loan. The loan is deemed to have been made from the general assets of the insurance company, not as a withdrawal from the accumulated cash value of the policy. If the insured dies before the loan is repaid, the amount of the loan and accrued interest is deducted from the death benefit payable under the policy. Some whole life insurance policies permit the policyholder to access the cash value by making withdrawals therefrom. Withdrawals reduce the death benefit; however, the policyholder has no obligation to repay amounts withdrawn, nor is there any interest obligation on the amount withdrawn. Many whole life insurance policies have an additional mechanism for distributing benefits to the policyholder, known as dividends. Such policies, which are called “participating” policies, provide the opportunity for the insurance company to distribute additional value to the policyholder in the form of dividends. Dividends may be paid in cash, credited against premiums due, or they may be accumulated and added to the cash value. Generally, dividends are paid when the insurance company’s operating results have exceeded its profit expectations and there are additional funds available for distribution to policyholders. Policyholders do not have a right to receive dividends, they are payable in the discretion of the insurance company. Today, there is a great deal of flexibility in the structuring of life insurance policies with respect to premiums, death benefits and other benefits. Premiums may range from a single payment to a lifetime of payments. They may be fixed or variable in amount. Death benefits may be fixed or variable and there are many permutations of other policy benefits, such as cash value, policy loans, and dividends. In the past, the traditional whole life insurance policy provided a fixed death benefit in return for fixed premiums payable for the lifetime of the insured, usually deemed to be ninety years. Such policies accumulated cash values in accordance with a schedule stipulated in the policy. The policyholder was not given any information about the insurance company’s cost of providing the death benefit, the amount of premium allocated to cash value, or the rate at which additions would be credited to cash value. The investment or savings component of the life insurance contract was hidden. In the late 1970s, a new form of cash value life insurance, known as “universal life,” was introduced to the market. In a universal life policy, all of the economic components of the policy are revealed. The introduction of universal life had a significant impact on the life insurance industry by providing a product that could be marketed with an emphasis on investment goals and returns. With the introduction of universal life, the flexibility of life insurance as an investment vehicle was enhanced and the variations in the kinds of policies multiplied. The tax advantages of life insurance Historically, Congress has deferred taxation of the inside buildup that occurs within a cash value life insurance policy. Additionally, death benefits have been exempt from taxation. Congress has, however, regulated and limited these substantial tax benefits by imposing restrictions on the amount of the investment component which can be built into a life insurance policy and by regulating the extent to which policyholders are permitted to access cash values without incurring tax consequences. Prior to the enactment of the Health Insurance Portability and Accountability Act of 1996 (“HIPA”), Pub.L. No. 104-191, 110 Stat.1936, 2090, corporate policyholders enjoyed another significant tax advantage, namely the full deductibility of interest on policy loans. The combination of deferral of taxation of inside buildup, the exemption of taxation of death benefits, and the deductibility of interest on policy loans created the opportunity for tax arbitrage by corporate policyholders. Not surprisingly, insurance industry entrepreneurs developed products for the corporate market which exploited this opportunity. Similar, although less sophisticated, products had been developed and marketed to high income individuals before Congress eliminated the deductibility of ordinary interest expense for individuals in the 1986 Tax Reform Act. Corporate-Owned, life insurance (COLI) Corporations have, for many years, purchased life insurance on the lives of their most valuable employees in order to protect the corporation against economic losses which would occur as a result of the untimely death of such an employee. This form of COLI is commonly known as key person life insurance. After it became widely accepted that corporations had an insurable interest in key employees, insurance companies began to market COLI as • a funding vehicle for deferred compensation plans, where the lives of the beneficiaries of the deferred compensation plans, usually executive-level employees, were insured and the death benefits were used to fund the deferred compensation obligation. When these kinds of insurance programs began to exploit the tax arbitrage opportunities inherent in COLI, through the use of large policy loans, and the interest deductions which they generated, Congress reined them in by eliminating the interest deduction on policies in excess of $50,000. See I.R.C. § 264(a)(4)(B) (1994). Insurance industry entrepreneurs soon found a way to circumvent this limitation by designing programs in which a corporation could purchase insurance policies on a large number or even all of its employees. These “broad-based” COLI plans could include any employee regardless of the length of employment or the value of the employee’s services to the corporation. Thus, by increasing the number of policies issued, the opportunity for policy loans and loan interest deductions could be multiplied while remaining within the $50,000 per policy loan limit. These efforts to continue the exploitation of the tax arbitrage opportunities of COLI caused Congress to consider additional legislation to limit or eliminate the deductibility of interest on policy loans. It was in this context that AEP made its decision to purchase broad based COLI covering over 20,000 of its employees. Related Litigation This is the third in a series of cases in which the IRS has challenged the deducti-bility of interest on policy loans in highly-leveraged broad-based COLI programs. See Winn-Dixie, Inc. v. Comm’r, 113 T.C. 254, 1999 WL 907566 (1999), and In re CM. Holdings, Inc., 254 B.R. 578 (D.Del.2000). The C.M. Holdings case is particularly relevant because it involved the same COLI plan purchased by AEP which was offered by the same insurer and sold by the same brokers. In C.M. Holdings, Camelot Music, Inc., a wholly-owned subsidiary of C.M. Holdings, Inc., purchased life insurance policies on the lives of 1,430 of its employees. The policies were in all relevant respects identical to those purchased by AEP. The arguments advanced by the parties were essentially the same as those advanced in the instant case. The IRS was represented by the same team of litigation counsel and the parties called most of the same witnesses who testified here, including the expert witnesses. The trial in C.M. Holdings commenced in late March, 2000, and lasted for six weeks. On October 16, 2000, Senior U.S. District Judge Murray M. Schwartz, issued a 143-page opinion, which marshals all of the facts and competing theories which these two highly complex cases share. The trial of the instant case commenced on October 30, 2000, and it also lasted six weeks. After thoroughly studying the court’s opinion in C.M. Holdings, it is apparent that this court has been presented with essentially the same evidence and the same legal arguments. This court has independently reached many of the same conclusions as the court in C.M. Holdings. In the interests of brevity and judicial economy, this court will make liberal use of the opinion in C.M. Holdings. AEP’s purchase of broad-based COLI Historically, AEP has provided medical benefits to its retired employees. Prior to 1993, Generally Accepted Accounting Principles permitted corporations to account for postretirement medical benefits on a “pay-as-you-go” basis. Thus, AEP reported the costs of medical benefits for retired employees as an expense at the time the benefits were paid. In the mid-1980s, the Financial Accounting Standards Board (“FASB”) announced that it was considering a change that would accelerate the recognition of postretirement medical benefits expense. Under this new method, postretirement medical benefits expense would be accrued and reflected in financial statements during the employees’ working years. The FASB indicated that it would also require the creation of a “transition liability” to recognize that no prior expense accruals had been made for postre-tirement medical benefits. This change in accounting rules, known as FAS 106, was issued in 1990 and became effective in 1993. Preliminary analysis performed by AEP staff and consultants in 1987 and 1988 indicated that FAS 106 would increase AEP’s annual expense for postretirement medical benefits from approximately $10 million on the pay-as-you-go basis, to $60-$80 million on the new accrual basis. This increase in expense would significantly reduce AEP’s reported net earnings. In early 1989, AEP formed an internal task force on postretirement benefits and charged it with the responsibility to analyze the effects of proposed FAS 106 and to develop solutions to the problems it would create. AEP also requested its actuarial consulting firm, Towers, Perrin, Foster & Crosby (“Towers, Perrin”) to evaluate the impact of the anticipated changes. As a public utility, AEP recovers the costs of providing services through rates charged to its customers, subject to the approval of federal and state regulators. It was unclear to AEP whether it would be permitted to pass on to consumers the incremental increase in benefits expense caused by FAS 106. AEP considered eliminating or severely reducing the medical benefits available to retirees but rejected this approach. AEP decided to attempt to recover its FAS 106 expenses through rate increases, and it sought ways to mitigate or offset its FAS 106 expense in order to enhance the possibility of obtaining the approval of regulators for rate increases. AEP’s consideration of purchasing broad-based COLI appears to have originated with AEP’s accountants, DeLoitte Haskins + Sells (“DeLoitte”). In October 6f 1989, Robert S. Gorab of DeLoitte mentioned the use of COLI for the purpose of offsetting anticipated FAS 106 expenses in a telephone conversation with Gerald P. Maloney, AEP’s chief financial officer. Gorab followed up by sending Maloney materials he had received from the insurance brokerage firm of Alexander and Alexander. These materials described a COLI plan offered by New York Life Insurance Company and included a paper entitled “METHODS TO PRE-FUND POST-EMPLOYMENT MEDICAL BENEFITS.” J1273. Maloney had pri- or experience with COLI in connection with the funding of senior executive’s de: ferred compensation plans in 1982 and 1986, in which life insurance was purchased on the lives of key executives in order to fund the deferred compensation. Maloney assembled a group of AEP executives and employees to assist him in deciding whether to recommend COLI to AEP’s top management, Chairman of the Board and Chief Executive Officer W.S. White, Jr. and Chief Operating Officer and President Richard S. Disbrow. Maloney sent the Alexander and Alexander materials on to L.V. Assante, AEP’s assistant treasurer, for his comments. On November 27, 1989, Assante, with the assistance of an AEP accountant, Hugh McCoy, provided Maloney with a memorandum containing an analysis of the New York Life COLI plan, which indicated that the plan would produce income that would offset a significant portion of the accruals for postretirement benefits expense over a thirty-year period. The memo concluded with the following statement: This appears to be a good funding vehicle over the long run but in the early years (and perhaps in total for AEP) it will not completely offset the increase in expense related, to postretirement medical benefits that will result if the FASB’s Exposure Draft becomes a final Statement. J748. In January, 1990, Maloney received another presentation on the use of COLI to fund postretirement medical benefits from James Campisi, who represented a joint venture between his firm, The Newport Group (“Newport”), and the insurance brokerage firm of Johnson & Higgins. Campisi provided Maloney with information regarding a COLI plan offered by Mutual Benefit Life Insurance Company (“MBL”), which included schedules showing the projected performance of the MEL COLI plan based on 20,000 employees and 7 annual premiums of $16,667 per employee. The COLI plan proposed by Campisi contemplated substantial policy loans during the first three years, with the proceeds applied to the payment of premiums. The premiums for the next four years would be largely offset by dividends and withdrawals of cash value and no premiums would be due after the seventh year. The projected performance of the plan produced positive cash flow and earnings every year for the life of the plan. Maloney and the members of his group met with Campisi on January 26, 1990. Campisi explained the benefits of the MBL COLI program. Issues discussed at this meeting included: (1) whether AEP had an insurable interest in the employees sought to be covered; and (2) how the laws of the various states in which AEP had employees might affect that issue. Campi-si pointed out that taxable income was necessary to realize the tax benefits contemplated by the program. Campisi offered to provide Maloney with a so-called “sweetheart letter” which guaranteed that the plan could be “unwound” any time before December 31, 1990, at no cost to AEP, in the event Congress and the President should approve tax legislation which would adversely affect the plan. On January 31, 1990, Campisi sent Ma-loney a packet of materials which included policy applications and prepayment agreements. Maloney asked McCoy to review Campisi’s proposal and McCoy provided him with a memorandum dated February 6, 1990, with attached schedules. See J752. McCoy pointed out that after the first three years of the program, policy loans would total nearly $1 billion and would generate interest expenses of approximately $130 million per year.. On February 7, 1990, Maloney forwarded Campisi’s materials on to Peter J. De-Maria, AEP’s treasurer and chief accounting officer, and M.R. Luis, AEP’s senior tax counsel. In this memorandum, Malo-ney commented on various aspects of the plan including the following: 8. I noted that the “tax benefit” amounts that are projected are very substantial and could possibly be challenged in some future audit by the IRS. Mr. Campisi stated that this coverage must qualify as “life insurance” under relatively objective and quantifiable standards of Section 7702 of the Internal Revenue Code; while it is possible that there could be such a challenge by IRS, there could be a reasonable defense because of compliance with those standards. J753. Maloney concluded his memorandum by stating that he had asked Mr. Luis to look into the questions of (a) insurable interest in the fives of retirees, and (b) exposure to a challenge by the IRS of the deductibility of interest charges on policy loans. On February 8, 1990, Luis provided Ma-loney with separate memoranda concerning these issues. In his one-page memorandum on the issue of deductibility of interest on policy loans, Luis stated: Since the pending COLI program, if adopted,- will generate substantial interest expense deductions, the IRS will scrutinize the transaction. If the COLI policies meet the section 7702 definition of a “fife insurance contract” and if the requirements of section 264 of the Code are met, the transaction along with its favorable tax attributes should not be challenged. Defendant’s Exh. D209. Maloney was satisfied with Luis’s response. The materials Campisi originally provided to Maloney were premised on a variable policy loan interest rate, which had a current rate of approximately thirteen percent. Maloney asked Campisi to provide him with additional schedules containing projections of performance based on lower policy loan interest rates. Campisi provided Maloney with this information in a letter dated February 7, 1990, which pointed out that the COLI plan provided a choice between 3 formulas for variable rates which, based on current rates, produced interest charges of 13.11%, 12%, and 10.91%. See J968. In each instance, the difference or “spread” between the policy loan interest rate ancl the crediting rate on encumbered cash value was fixed at one percent. Maloney selected the second option which produced a current policy loan interest rate of twelve percent. Maloney testified that he selected the middle rate because it approximated the rate AEP was then paying on its highest quality debt securities. He said he rejected the lowest rate because he wanted to maximize tax-deferred inside buildup and that he declined the highest rate because he thought it was too high and less defensible if questioned by the IRS. Maloney could have chosen an eight percent fixed rate but he gave that option no consideration because it would have been detrimental to the performance of the plan. Maloney convened another meeting of his group on February 12, 1990.' Maloney prepared a checklist for this meeting, which included an item entitled “IRS Dis-allowance of Interest Deduction.” This item included a reference to obtaining an opinion by AEP’s outside counsel, Simpson, Thatcher & Bartlett, followed by a question mark. Maloney testified that he ultimately decided to rely on Luis’s one-page memo instead of seeking an opinion from outside counsel, believing that he would receive the same opinion from outside counsel. At the conclusion of the February 12th meeting, Maloney decided to recommend that AEP proceed with the COLI program and instructed Campisi to prepare to bind coverage. Ma-loney informed AEP Chairman and Chief Executive Officer W.S. White, Jr. of his recommendation and inquired whether board approval would be necessary. White accepted Maloney’s recommendation and advised that board approval would not be necessary. White signed applications and prepayment agreements for 8 AEP operating companies on February 16, 1990, and on the same date checks were written by the AEP operating companies in an aggregate amount in excess of $4 million. On February 21, 1990, Maloney and Campisi appeared before the AEP Board to explain the COLI plan the company had just purchased. Maloney acknowledged that there was some urgency involved in consummating the purchase of the COLI plan because of the possibility that Congress might enact legislation restricting or eliminating the tax advantages of COLI. According to Ma-loney, however, everyone believed that existing plans would be “grandfathered” if that should occur. Shortly after executing the policy applications, AEP, at the suggestion of Campi-si, considered assigning the policies to a “grantor trust” sited in Georgia in order to realize substantial savings on premium taxes which would generate significant additional cash flow during the first five years of the COLI plan. Luis was given responsibility for completing this project. An appropriate trust agreement was prepared and executed on March 21, 1590. Campisi had advised that this should be done no later than March 22, 1990 because of potential adverse tax legislation and fear that a later date might jeopardize “grandfathering” the plan. On March 20, 1990, the chief executive officers of each of the AEP subsidiaries executed a revocable trust agreement assigning the MEL COLI policies on the subsidiaries’ employees to the Citizens and Southern Trust Company of Georgia, Trustee. The trustee accepted the assignments and executed the trust agreement on March 21,1990. The COLI policies were delivered on approximately March 23, 1990 and the balance of the cash portion of the first year’s premiums was transmitted by the AEP subsidiaries to the trustee which, in turn, paid MBL. The policies were made effective on February 16, 1990, the date of the prepayment agreements. The policy loans, which were used to finance a substantial part of the first year’s premium, were backdated to February 16, 1990, so that AEP could take advantage of the interest deduction for the entire year. AEP’s voluntary employees beneficiary association The transition liability that FAS 106 required companies to report as a liability on their balance sheet can be reduced by the fair value of assets segregated and restricted to be used for post-retirement benefits. Prior to the adoption of FAS 106, AEP had funded health plans for active employees through contributions to a Voluntary Employees Beneficiary Association (“VEBA”). While it was considering the COLI plan, AEP also considered creating a VEBA to fund the FAS 106 transition liability, and it ultimately did so. This VEBA, actually a partition of AEP’s existing VEBA, was funded through the purchase of trust-owned life insurance (“TOLI”) written by the Prudential Insurance Company of Newark, New Jersey. At its inception, this plan insured 845 employees under a group contract which was owned by the VEBA. Contributions to the VEBA are tax deductible and earnings on plan assets within the VEBA are sheltered from income tax. The VEBA, however, is not sufficiently funded to cover the full extent of AEP’s FAS 106 postretirement medical benefit liability. When AEP sought rate increases from the state regulatory agencies to cover its FAS 106 liability, it represented that it had mitigated its FAS 106 expense by funding a VEBA and by purchasing broad-based COLI. AEP represented that it would contribute the earnings realized by its COLI program to the VEBA. All of the regulatory agencies approved this approach and approved rate increases commensurate with the FAS 106 expense reductions which AEP projected would result from the VEBA and its COLI plan. The money contributed to the VEBA, which was invested in the TOLI plan, was used to purchase variable term life insurance policies, wherein the cash values would reflect the performance of a bond fund and the Standard and Poor’s 500 Stock Index. Mr. Maloney testified that the TOLI plan has performed very well, earning close to a twenty percent per year increase in the S & P fund component and approximately 7% per year in the bond fund component. Unlike the COLI plan, the TOLI plan does not rely on the tax deductibility of interest on policy loans. Development Of MBL COLI Plan The idea behind the MBL COLI Plan was conceived in 1985 by Henry F. McCamish (“McCamish”), a life insurance entrepreneur. McCamish retained Milkman and Robertson (“M & R”), a nationally prominent actuarial consulting firm, to develop a new type of COLI product. McCamish asked M & R to design a COLI policy for large corporations that had policy value at the end of the first policy year that exceeded the first year’s premium, so that the policy value would support a policy loan large enough to cover most of the first-year premium. He also stipulated that the policy should generate positive earnings and cash flow in the first plan year. Stephen Eisenberg (“Eisenberg”), Managing Consulting Actuary of M & R’s life insurance practice, was the principal architect of this new form of COLI. He was assisted by Timothy Millwood, another M & R actuary. In designing the policy, Eisenberg had to ensure that it complied with all pertinent existing provisions of the Internal Revenue Code, including I.R.C. §§ 264 and 7702. Thus, Eisenberg had to design a plan in which the policyholder would not take policy loans in four out of the first seven policy years. • McCamish, who was a personal friend of the president of MBL, procured MBL’s agreement to underwrite the new COLI product being designed by Eisenberg. James Van Etten, an actuary employed by MBL, collaborated with Eisenberg while he was designing the policy. McCamish formed two corporations that provided administrative and consultive services for the new MBL COLI policies, Integrated Administration Services, Inc. (“IAS”) and IAS Development Corporation (“IDC”). As compensation for these services, MBL agreed to pay McCamish and his companies a policy administration fee for every COLI policy sold, as well as a percentage of the annual premiums generated by the policies. By early 1986, M & R, MBL and McCamish had developed MBL policy form FA85, which was designated as “COLI I”. Thereafter, policy form FA85 was modified at various times in response to changes in the tax laws and competitive pressures in the marketplace. The modifications were made by adding a series of endorsements or amendments to the form. Each new version of the policy was sequentially numbered in Roman numerals. The COLI III policy was created in late 1986 in response to the amendment of I.R.C. § 264, which limited the deductibility of policy loan interest to $50,000 per insured. The COLI III policy initiated the use of dividends to offset payments of premiums in four out of the first seven policy years. The COLI V policy modified COLI III by making premiums payable for only a defined number of years. It contemplated that premiums would stop once the policyholder reached the $50,000 loan limit of I.R.C. § 264(a)(4)(B) and the requirements of the four out of seven safe harbor of § 264(c)(1) had been satisfied. Thus, the premiums stopped after seven years, and thereafter, the policyholder would hold the policies under an extended term nonforfeiture option. Finally, the COLI VIII policy modified COLI V by reducing the amount of premium per $1,000 of death benefits. This was done to ensure compliance with I.R.C. § 7702(a), which placed a cap on the premium per thousand in life insurance contracts. Features ofAEP’s COLI VIII policies and plan The COLI VIII policies purchased by AEP were issued by MBL on policy form FA85 with endorsements EFA85-3, EFA85-4, EFA85-6, and EFA85-7. The policies are denominated on their face “Increasing Death Benefit Whole Life” with “premiums fixed and payable during lifetime of insured or until end of premium period” and “Eligible for Dividends.” While the amount of the death benefit would vary depending upon the age of the insured employee, the remaining terms of each of the policies were identical. Each had a fixed annual premium of $16,667. The policies provided for three interest rates: (1) the policy loan interest rate; (2) the loaned crediting rate, called the “Current Credited Loan Interest Rate,” which was the rate at which the company would increase the amount of the cash value of the policy used to secure policy loans; and (3) the unloaned crediting rate, called the “Current Unloaned Interest Rate,” which was the rate at which the company would increase the amount of the cash value not used to secure policy loans. The loan interest rate and the loaned crediting rate were set as follows. The policies permitted AEP to annually elect between a fixed or variable loan interest rate. The fixed loan interest rate was 8% per annum if charged in arrears or 7.4%, if charged in advance. If AEP selected the fixed loan interest rate, the loaned crediting rate would be the greater of a rate declared by MBL or 4%. If AEP elected the variable loan interest rate, the loan interest rate would be the greater of: (1) the Moody’s Corporate Band Yield Average — Monthly Average Corporate (“Moody’s Corporate Average”) or (2) the loaned crediting rate plus 1%. Under the MBL COLI policy form, the loaned crediting rate would be equal to Moody’s Corporate Bond Yield Average — Monthly Corporate Baa. (“Moody’s Baa”). Moody’s Baa has always exceeded Moody’s Corporate Average by 0.60% to 1.00%. Accordingly, the second prong of the variable loan interest rate provision would always govern and the' loan interest rate would always be equal to the loaned crediting rate plus one percent. Under endorsement EFA 85-3, the loaned crediting rate was calculated according to the following mathematical formula: Baa + T% 100% - Baa This formula produces a rate higher than Moody’s Baa even when T = 0. This rate (T = 0) will be referred to. as “Moody’s • Baa enhanced.” While AEP was considering the MBL COLI plan, it was given a choice of variable loan interest rates which were determined by adding 1% to 3 possible loaned crediting rates: Moody’s Baa (based on the standard policy form FA 85); Moody’s Baa enhanced (based on endorsement EFA 85-3 with T equal to 0); and Moody’s Baa enhanced plus 1% (based on endorsement EFA 85-3 with T equal to 1). AEP chose Moody’s Baa enhanced, which resulted in a loaned crediting rate of eleven percent and a policy loan interest rate of twelve percent. As a result, the policies were issued with endorsement EFA 85-3 and the factor “T” was set at 0. Before it purchased the COLI policies, AEP was provided with sets of financial projections called “issue illustrations” which demonstrated how the COLI plan would perform in terms of cash flow and earnings. An issue illustration entitled “Scenario II” demonstrated the projected performance of the plan based on the policy loan interest rate AEP selected. See J968. This issue illustration demonstrated how the COLI policies were intended to be operated and the economic benefits they were expected to produce during the first 20 years of the plan, based on a corporate income tax rate of 37% and 20,000 insured employees. The following table (J968) shows the cash flow analysis' presented in Scenario II for the first ten years of the plan. SCENARIO II CORPORATE OWNED LIFE INSURANCE CASH FLOW ANALYSIS (OOO’s OMITTED) The MBL COLI VIII policies were designed to have fixed annual premiums payable on the first day of each policy year. AEP selected the highest possible annual premium of $16,667 per policy, which permitted the accumulation of $50,000 in cash value in the shortest possible time, i.e. three years. The first year’s total premium was calculated at $333,340,000. Premiums for the next 6 years were projected to be in the range of $331 million to $333 million. During the first through third years, the plan called for AEP to pay approximately ninety percent of the annual premiums through policy loans in simultaneous netting transactions in which the loans were offset against the premiums. Instead of paying $330 million in cash for the first year’s premium, AEP would actually pay about $21 million (plus $2.5 million in first-year administrative fees.) This cash payment of approximately $23.5 million would be offset by the tax benefit of deducting the policy loan interest expense ($13.8 million) and by the receipt of tax-free insurance proceeds in the amount of $10.8 million. The net result would be positive cash flow of approximately $3.5 million the first year. Positive cash flow increased to approximately $3.9 million the second year, $10.5 million the third year and then quickly escalated to an amount in excess of $35 million per year by the eighth policy year. After the third policy year, AEP could no longer finance the premiums with policy loans since this would violate the $50, 000 per policy loan limit of I.R.C. § 264 and forfeit the tax deductibility of the policy loan interest. The COLI policies were designed so that in years four through seven, most of the annual premiums and accrued loan interest would be paid by dividends and partial withdrawals In simultaneous netting transactions, which would occur on the first day of each of those policy years. In these annual transactions, approximately ninety-five percent of the annual premium was considered taken by MBL as an expense charge. After setting aside amounts sufficient to cover MBL’s actual expense charges, the remainder was returned to AEP as a “loading dividend” offsetting ninety-five percent of the premiums due. No additional premiums were due after year seven and the loading dividends ceased. The policy loans remained in ef-feet, however, generating interest expense in excess of $100 million annually, which was substantially offset by cash value withdrawals. Positive cash flows in the range of $35 million to $39 million were projected through year 20. The AEP COLI VIII policies were projected to have a net equity equal to zero at the end of each and every policy year. The net equity, also known as cash surrender value, is equal to the total policy value, less policy loans and accrued interest. When a policy has a net equity equal to zero, all of the policy value is encumbered and it cannot support any additional policy loans. The designers of the MBL COLI plan 'used a sophisticated computer program to perform the calculations necessary to achieve this result. AEP’s MBL COLI * program was designed to be “mortality neutral,” to wit, the program’s design was that the cumulative COI charges that AEP paid would equal the cumulative death benefits that it would receive, minus a profit margin to MBL of 20% of COI in the first year, 10% the second year and 2% each year thereafter. The concept of mortality neutrality was explained and described in M & R documents as follows: Since the sale is tax driven, mortality should play a neutral role in performance. That is, clients usually do not expect to make or lose money on their mortality experience. They expect to realize the illustrated cash flows each year. D325. Policyholders typically do not buy these products for mortality gains. They only expect to be treated fairly with respect to mortality. They expect COI rates will increase if experience so indicates. Likewise, they expect that favorable experience will result in increased policyholder dividends. In other words, COLI policyholders enter these contracts as a partnership with the insurance carriers with neither party taking advantage of the other party. D580. MBL’s commitment to mortality neutrality was reflected in a mortality dividend declared in 1991 for all plans issued through 1989 and a pledge to make annual mortality dividends thereafter, if mortality experience continued to prove more favorable to the company than expected. MBL’s successor, Hartford, carried out this commitment to mortality neutrality by instituting experience rated dividends for the ten largest COLI plans, including AEP. Campisi advised AEP that “this mortality mechanism will result in a much closer match between expected cash flow from projected death benefits and claims that are actually paid. This will eliminate any volatility or variation in the cash flow that we are expecting in each year of the plan.” D387. The essential features of the AEP MBL COLI VIII plan can be summarized as follows. First, the COLI plan had a very high policy value on the first day of the first year of the policy. This was made possible by the highest possible premium per policy and the broad base of employees insured. The high first year policy values were also made possible by the agents foregoing first-year commissions. Sécond, the high policy values were used to secure maximum policy loans, which paid a substantial amount of the premiums due in the first three policy years and also produced substantial interest deductions that, when combined with projected tax free death benefits, fueled positive cash flows. Third, computer technology enabled maximum leveraging of the high policy values through programs designed to achieve zero net equity at the end of each policy year. Fourth, AEP had the right to select among crediting rates for the inside buildup on the loaned portion (ie., virtually all) of the policy value, which automatically determined the policy loan interest rate because of the one percent spread between the loaned crediting rate and the policy loan rate. Fifth, the one percent spread essentially fixed AEP’s cost of borrowing with the counter-intuitive result that the higher the loan interest rate paid by AEP, the greater the cash flow to it as a result of higher interest deductions. Sixth, the COLI VIII plan had an extremely high expense load component in policy years four through seven, which was used to create first-day dividends, which were used to pay most of the premium charges for those years. Finally, the actual cost of providing the death benefits was carefully calibrated to equal the amount of death benefits which AEP would receive over the life of the plan so that, except for MBL’s modest profit on COLI profit, there would be no gain or loss based on mortality experience. Thus, through a preplanned, highly structured and calibrated combination of features, AEP’s broad-based leveraged COLI plan was designed to produce positive cash flows in each and every plan year using the tax benefits of the deductibility of policy loan interest, deferral of taxation of inside buildup, and nontaxation of death benefits to transform paper losses into positive earnings and to generate, substantial positive cash flows totaling over half a billion dollars at the end of twenty years. The sham transaction doctrine The government contends that the loading dividends, policy loans, and partial withdrawals that are all components of AEP’s MBL COLI plan are factual shams. The sham transaction doctrine originated with the Supreme Court decision of Gregory v. Helvering, 293 U.S. 465, 55 S.Ct. 266, 79 L.Ed. 596 (1935). In Gregory, the Court affirmed the Commissioner’s denial of deductions claimed by taxpayers for losses and expenses incurred in a corporate reorganization. Although the taxpayers had followed each step required by the Internal Revenue Code for the reorganization, the Court nonetheless held these losses nondeductible, finding that the transaction was a “mere device” for the “consummation of a preconceived plan” and not a reorganization within the intent of the code as it then existed. Id. at 469, 55 S.Ct. 266. Because the transaction lacked economic substance, it was not “the thing which the statute intended.” Id. The sham transaction doctrine requires the court to examine a challenged transaction as a whole and each element thereof to determine if the substance of the transaction is consistent with its form. See ACM P’ship v. Comm’r, 157 F.3d 231, 247 (3rd Cir.1998), cert. denied, 526 U.S. 1017, 119 S.Ct. 1251, 143 L.Ed.2d 348 (1999). If the form of a transaction complies with the Code’s requirements for deductibility, but the transaction neverthe less lacks factual or economic substance, then expenses or losses incurred in connection with the transaction are not deductible. See Knetsch v. United States, 364 U.S. 361, 369, 81 S.Ct. 132, 5 L.Ed.2d 128 (1960); United States v. Wexler, 31 F.3d 117, 122 (3rd Cir.1994), cert. denied, 513 U.S. 1190, 115 S.Ct. 1251, 131 L.Ed.2d 133 (1995). The burden of proof is on the taxpayer to show that the form of the transaction reflects its substance. National Starch and Chem. Corp. v. Comm’r, 918 F.2d 426, 429 (3rd Cir.1990) (“burden is on the taxpayer to show that the expenses are deductible”) aff'd sub nom INDOPCO, Inc. v. Comm’r, 503 U.S. 79, 112 S.Ct. 1039, 117 L.Ed.2d 226 (1992); Goldberg v. United States, 789 F.2d 1341, 1343 (9th Cir.1986). While a taxpayer can legitimately structure a transaction to minimize tax liability under the Code, the transaction must nevertheless have factual and economic substance. See Gregory, 293 U.S. at 469, 55 S.Ct. 266. AEP contends that the sham transaction doctrine includes a threshold requirement which requires the court i¡o first determine “whether the thing done was the thing intended by the statute.” Plaintiffs Posi>-Trial Memorandum at p. 32. According to AEP, if the court determines that the thing done was indeed the thing intended, the court need not and should not proceed to examine the issue of whether the transaction has economic substance. AEP argues that Congress has, over the years, carefully tailored the tax laws relating to the favorable treatment of life insurance, and since AEP’s COLI plan satisfies all of the statutory requirements for the tax favored treatment of inside buildup, death benefits, and policy loan deductions, the plan satisfies the statutory intendment test and the judicial inquiry is at an end. AEP’s statutory intendment test is taken from the following language in Gregoi'y: The legal right of a taxpayer to decrease the amount of what otherwise would be his taxes, or altogether avoid them, by means which the law permits, cannot be doubted. But the question for determination is whether what was done, apart from the tax motive, was the thing which the statute intended. Gregory, 293 U.S. at 469, 55 S.Ct. 266 (citations omitted). AEP reads too much into this statement. Certainly, the Court did not mean that satisfying all of the statutory requirements precludes a court from examining either the factual reality or the economic substance of the questioned transaction. Indeed, in Gregory, the Supreme Court went on to note.- “[n]o doubt, a new and valid corporation was created. But that corporation was nothing more than a contrivance,” and “[t]he whole undertaking, though conducted according to the terms [of the statute] was in fact an elaborate and devious form of conveyance masquerading as a corporate reorganization, and nothing else.” Id. at 469-70, 55 S.Ct. 266. AEP’s statutory intendment test would effectively swallow up the economic substance test and vitiate the sham transaction doctrine. A transaction which has no factual reality or economic substance can never be the thing the statute intended even though the form of the transaction satisfies all of the requirements of the statute. AEP argues that the Supreme Court’s opinion in Hanover Bank v. Comm’r, 369 U.S. 672, 82 S.Ct. 1080, 8 L.Ed.2d 187 (1962) and the Sixth Circuit’s opinion in Humphreys v. Comm’r, 301 F.2d 33 (6th Cir.1962) are “clear examples of the application of the statutory intendment standard.” Plaintiffs Post-Trial Memorandum at p. 35. However, neither of these cases support AEP’s argument. In Hanover Bank, the question before the Court was one of pure statutory construction. The Court specifically noted that the “Government does not contend that the transactions entered into by the petitioners were a sham without any business purpose except to gain a tax advantage.” Hanover Bank, 369 U.S. at 681, 82 S.Ct. 1080. In Humphreys, the Sixth Circuit specifically found that “[i]t cannot be controverted that the purchase of the bonds and the gifts to charity were real genuine transactions though motivated by tax considerations.” Humphreys, 301 F.2d at 33-34. Neither case involved the application of the sham transaction doctrine. The taxpayers in CM. Holdings, and Winn-Dixie raised arguments similar to AEP’s statutory intendment argument and they were rejected. See C.M. Holdings, 254 B.R. at 636 and Winn-Dixie, 113 T.C. at 290, 294. This court agrees. Courts have recognized two basic types of sham transactions: (1) “shams in fact,” in which the reported transactions never occurred; and (2) “shams in substance” in which the transactions “actually occurred but which lack the substance their form represents.” Kirchman v. Comm’r, 862 F.2d 1486, 1492 (11th Cir.1989); see also ACM P’ship, 157 F.3d at 247 n. 30; Lerman v. Comm’r, 939 F.2d 44, 49 n. 6 (3d Cir.1991). The government claims that the loading dividends, policy loans, and partial withdrawals under AEP’s MBL COLI plan are factual shams and that the AEP MBL COLI plan as a whole was a sham in substance because it was devoid of economic substance apart from the policy loan interest deductions. Sham in fact doctrine as applied to components of the AEP COLI PLAN Policy loans The government contends that the policy loans were factual shams. Here, in addition to the decisional law relating to the sham transaction doctrine, the government relies on a separate body of case law defining interest and indebtedness for the purpose of determining the deductibility of interest under I.R.C. § 163. This line of cases stands for the proposition that interest and indebtedness must be real in order to support a deduction. See Knetsch, 364 U.S. at 369, 81 S.Ct. 132; Wexler, 31 F.3d at 122; Goldberg, 789 F.2d at 1343; Bridges v. Comm’r, 325 F.2d 180, 181-82 (4th Cir.1963). Section 163 allows a deduction for “interest paid or accrued within the taxable year on indebtedness.” I.R.C. § 163. “Interest” represents compensation for the use or forbearance of money. Old Colony R. Co. v. Comm’r, 284 U.S. 552, 561-62, 52 S.Ct. 211, 76 L.Ed. 484 (1932). “Indebtedness” under I.R.C. § 163 is defined as “an unconditional and legally enforceable obligation for the payment of money.” Autenreith v. Comm’r, 115 F.2d 856, 858 (3rd Cir.1940). According to the government, AEP’s COLI policy loans and their associated interest deductions lacked both factual and economic reality because: 1) the COLI loan interest rates were not determined by the market in an arm’s-length transaction but were arbitrarily chosen in a collusive arrangement for the purpose of maximizing interest deductions; 2) they violated industry standards governing maximum permissible loan interest rates; and 3) the rates were excessive and unjustifiable from a financial perspective. Most of the arguments advanced by the government for the proposition that the policy loans were factual shams are more appropriately addressed to the issue of whether the policy loans were economic shams. The court is satisfied by a preponderance of the evidence that the policy loans were not factual shams. The COLI policy loans were considered real debts of AEP, which had to be repaid when the insured employee died or if the policy lapsed. Whenever an insured employee died, the death benefit was reduced by the outstanding policy loan and unpaid interest. MBL and its successor, Hartford Life Insurance Company (“Hartford”) carried the policy loans as assets on their books and recorded them separately from the receipt of premiums. In the aftermath of HIPA, AEP repaid the loans on all policies in excess of 20,000 employees with substantial amounts of cash. All insurance policy loans seem rather unreal when compared to ordinary commercial loans. It is the longstanding custom and practice in the insurance industry that policy loans are deemed as made from the general funds of the insurance company, with the policy value serving only as collateral. They are not considered withdrawals of cash from the policy value itself. As the court observed in C.M. Holdings: One can think of the life insurance company acting somewhat like a bank, lending money to the policyholder from its general funds, with the policy value pledged as collateral. C.M. Holdings, 254 B.R. at 602. The fact that the policy loans were made on the first day of each policy year does not deprive them of reality. There is precedent in the industry for first-day, first-year policy loans. It is not unusual for policy loans to be applied to offset premiums in a simultaneous netting transaction. First-day, first-year policy loans that were credited against premiums were not regarded as factual shams in Campbell v. Cen-Tex, Inc., 377 F.2d 688 (5th Cir.1967) and Woodson-Tenent Labs., Inc. v. United States, 454 F.2d 637 (6th Cir.1972). The risk characteristics of the loans do not affect their factual reality. Indeed, all life insurance policy loans are devoid of most of the major risk factors which are present in commercial loans. It is the custom of the industry to set interest rates on policy loans without reference to the risk factors that attend ordinary commercial loans. The government’s argument that the policy loan interest rate was set at an artificially high rate in a collusive non-arms-length transaction does not implicate the reality of the transaction. Interest rates on insurance policy loans are always determined in private transactions between the insurance company and the policyholder, and are customarily determined by the terms of the insurance contract issued by the insurance company and accepted by the policyholder. There is no market rate for such loans, as there is in the case of real estate mortgages or commercial loans. There is ample precedent for variable rates based on standards such as Moody’s Corporate Average. Fixed spreads between policy loan interest rates and cash value crediting rates are not unusual. The fact that the MBL COLI policies gave the policyholder a choice of rates higher than Moody’s Corporate Average, by linking them to Moody’s Baa (plus a choice of enhancements), does not affect the reality of the loans. Backdating of the first-year policy loans When AEP decided to participate in the MBL COLI plan, it entered into prepayment agreements, which were signed on February 16, 1990, wherein the AEP companies agreed to pay $200 per insured to purchase insurance from the date of the prepayment agreements to the date of policy issue. The prepayment amount was to be applied to the first premium due if the policies were issued. Under the terms of the prepayment agreements, coverage was to end on the earlier of: 1) sixty days from the date of the prepayment agreement; 2) the date the policies were issued; 3) the employer’s failure to pay premiums on policy delivery; or 4) upon MBL’s disapproval of the application for insurance. The prepayment agreements expressly provided that “accumulation or credit of interest on policy values and charges for policy loan interest as provided in the policy shall accrue only from the date of policy issue.” J761. Thus, the prepayment agreements did not require AEP to pay any policy loan ■interest until MBL actually issued its policies. The policies were issued and delivered on March 23, 1990. The policies and the policy loans were backdated to the date of the prepayment agreements, February 16, 1990, and AEP claimed interest deductions on the policy loans from that date. AEP was not obligated to pay any loan interest during the period of the prepayment agreement. No loans existed during that period. MBL did not provide AEP with any funds during that period, nor did any policies exist which could be have been used as collateral for policy loans. McCamish’s company, IAS, which was responsible for the administration of the MBL COLI policies, originally calculated the interest on the first year of the policy loans based upon an inception date of March 23, 1990, the date the policies were delivered. This was later changed at the urging of Campisi after AEP complained that it reduced the projected positive after-tax cash flow for the first year from $3,000,000 to a little over $1,000,000. The illusory nature of the inception date of the policy loans and the fictitious obligation for the period from February 16, 1990, to March 23, 19’90, is further revealed by the fact that the COLI policies were deemed to have been transferred to a grantor trust on March 21, 1990. Thus, by backdating the policy loans, the trust purportedly became liable for interest for a period predating its legal existence. The predating of the policy loans and the creation of an interest obligation for the period February 16th through March 23, 1990, were shams in fact. While there was evidence presented showing that it is common in the life insurance industry to issue a conditional receipt at the time of taking an application for life insurance and to provide death benefit coverage from the date of the receipt — after it has been determined that the insured meets the company’s underwriting requirements — there was no evidence presented of a custom or practice to backdate policy loans in the manner in which it was done in the instant case. The court concludes that the manner in which IAS originally intended to calculate the first-year policy loan interest is more likely the industry norm for a transaction of this kind. Loading dividends and premiums in policy years four through seven The government contends that the loading dividends which offset most of the premium expense in policy years four through seven were factual shams. In C.M. Holdings, the court aptly described these transactions as follows: In the simultaneous netting transaction involving the loading dividends, the premiums come from the policyholder, the loading charges come from the premiums, the loading dividends come from the loading charges, which dividends are then used by the policyholder to pay the premiums. Since the funds for each component is source from another component in a circular transaction, the entire transaction is simply a paper ruse. C.M. Holdings, 254 B.R. at 608. It is standard practice for life insurance policies to have loading charges to cover the insurance company’s expenses in administering the policy. It is also standard practice to assess loading charges greater than the anticipated expenses in order to provide a reasonable margin of safety to cover unpredictable expenses, to make a permanent contribution to surplus, and to provide for the payment of dividends in the event of favorable experience. However, such charges customarily have a reasonable relationship to the insurance company’s risk of incurring higher than expected expenses. The government experts provided credible expert testimony that margins of five to ten percent would be generous. There is some degree of flexibility in industry practices ' with respect to the amount of loading charges, which relates to how a company wishes to present itself in the market place with respect to premiums and dividends. Higher premiums permit the payment of higher dividends and lower dividends result in lower premiums. The loading dividends in this case are nevertheless far beyond the range of standard industry practices. The following table shows the expense loads assessed in the MEL COLI policies as a percent of gross premium and MBL’s actual anticipated policy expenses as a percent of gross premium for policy years one. through seven: Contractual MBL’s Anticipated Expense Loads Policy Expenses Plan (As % of (As % of Year Gross Premium) Gross Premium) 10% 4.0% h 20% 8.8% to 30% 8.8% w 95% its. 95% 9.3% cn 95% 9.3% o 95% -a D561. In years four through seven, the contractual expense load was ninety-five percent of the gross premium, whereas MBL’s actual anticipated policy expenses as a percentage of gross premium was less than ten percent. The excess was the source of the huge loading dividends, w